Reciprocal Outsourcing by EDS and WorldCom, Inc.

Posted October 16, 2009 by   · Print This Post Print This Post

In July 2002, the EDS share price was rocked by the sudden decline and subsequent bankruptcy filing of WorldCom, Inc., a telecom services company. In October 1999, EDS had entered into a reciprocal deal with WorldCom, where EDS was providing IT services and EDS agreed to act as a reseller for WorldCom. The total of both deals was to exceed $12 billion over an 11 year period.

What caused EDS to suffer in 2002? Did the deal terms adequately protect it? Is this a “failed deal”?

The EDS-WorldCom Agreements.

As of July 2002, the entire relationship consisted of essentially three contracts, two of which are essentially reciprocal agreements for different types of services.

1. IT Services Agreements:
EDS provides IT services to WorldCom, the majority of which are provided under an 11-year, $6.4 billion agreement signed in October 1999. Other IT services agreements exist, but the October 1999 agreement covers the majority of IT services.

2. Network Services Agreement:
WorldCom provides telecom network services to EDS under an 11-year, $6.0 billion agreement signed in October 1999. Outsourced functions include network operations, management and engineering.

3. Fiber Optic Equipment Leveraged Lease:
EDS invested an unrecovered $40 million (approximately) in a 1988 fiber optic leveraged lease agreement with a predecessor to WorldCom.

Key Terms of the EDS-WorldCom Agreements.

1. IT Services Agreements:
EDS announced in July 2002 that the 1999 IT services agreements are for 11 years. The ITS services agreements appear to provide customary fee-for-service obligations.

2. Network Services Agreement:
WorldCom provides telecom network services to EDS under an 11-year, $6.0 billion agreement signed in October 1999. Unlike the normal fee-for-service obligations, this agreement contained “take-or-pay” payment obligations requiring EDS to pay for telecom network services even if it did not use the full capacity. According to a press release by EDS on July 1, 2002:

There are two components of EDS’ annual revenue commitment to WorldCom:

a. A cumulative take-or-pay revenue threshold of $400 million per year that increases during the terms.

b. A higher cumulative threshold of $600 million per year, which includes the previously mentioned $400 million threshold.

In the event that EDS fails to meet the higher annual threshold, EDS would be obligated to pay WorldCom 20% of the difference between EDS’s actual spending and the higher threshold. Thus, for variable consumption of network services below the top threshold, EDS would pay 20% of the shortfall.

EDS is also obligated to pay 100% of any shortfall below the $400 million take-or-pay threshold. Thus, for variable consumption of network services below the bottom threshold, EDS would pay 100% of the shortfall.

Under these terms, EDS guarantees payment of at least $400 million annually, whether or not EDS’s actual needs required the services. EDS assumed the risk of its own planning and forecasting for its demand for the outsourced services. If the usage meets the $400 million annual minimum, then EDS’s amount at risk declines from 100% to 20% of the shortfall to the next threshold. In essence, EDS committed to pay at least $400 million plus 20% of ($600 million less $400 million), or $40 million, or a total of $440 million per year.

Common Elements of Each Reciprocal Outsourcing Deal.

1. Duration.
Each reciprocal outsourcing deal was for the same term, consisting of 10 years plus one start-up year.

2. Transfer of Employees.
In 1999, because EDS assumed responsibility for IT system operations at more than a dozen MCI WorldCom processing centers worldwide, EDS agreed to hire approximately 1,300 MCI WorldCom employees. To support WorldCom’s provision of “select functions” of EDS’s global network services to EDS, WorldCom agreed in 1999 to hire approximately 1,000 employees of EDS.

3. Transition Plan.
Each agreement required a one-year transition plan. The transfer of employees, for example, was not to be complete until after the initial year.

4. Limited Scope.
Each company outsourced only a limited number of functions. This was not a total outsourcing creating a massive dependency, but one with substantial scope and limited dependencies.

5. Inflation Adjustment.
The announced terms of the IT services agreement did not discuss inflation. However, the network services agreement expressly included an inflation adjustment.

Critique.

1. Design of a Reciprocal Outsourcing.
The key to successful reciprocal agreements lies in reciprocity and mutuality of obligations, benefits, timing and risk assumption. The deals undoubtedly followed this model, but there is no showing of a right of EDS to terminate one agreement for a default by WorldCom in the other. The wind-down issues and other rush management strategies have not been detailed. Thus, the public disclosures that we have seen do not address concerns of investors and clients about the inability of one party to perform its obligations due to a sudden decline in its financial condition (such as the restatement of earnings by WorldCom of $3.8 billion in July 2002).

2. Outcome of WorldCom’s Financial Difficulties.
WorldCom’s bankruptcy in July 2002 is the biggest bankruptcy in U.S. history. But the total collapse and liquidation of a $107 billion company is not certain in light of its 20 million long-distance (MCI) users. EDS did offer, as part of its business continuity planning, to assist customers in finding other telecom suppliers, but that may be impossible given the size of WorldCom’s market share in certain key markets. Accordingly, the reorganization under bankruptcy could conceivably result in a leaner, more competitive WorldCom, free of certain past debt load, with better pricing for EDS and its customers.

3. Is this a Failed Deal?
This strategic relationship may be a “failed deal” because there is a significant loss. But the benefits may outweigh the loss.

In 1999, there was no way to predict that WorldCom would fall into bankruptcy in 2002. While EDS might suffer a loss of pre-petition receivables from WorldCom (estimated at approximately $150 million as of June 30, 2002) and unbilled revenue of about 40% of that amount (for another $60 million), a $210 million loss might not be a bad price to pay for the substantial benefits of a deal that has generated several hundred million dollars and continues to generate approximately $160-175 million per quarter in 2002.

UPDATE December 2002:

Bankruptcy: EDS pays off its Customer WorldCom.
EDS agreed to pay $187 million to WorldCom in Chapter 11 extended over a year, with the bulk being paid in four months. In return, WorldCom agreed to pay $15 million to EDS for reimbursement of expenses paid to local telephone companies. But is this a bankruptcy law problem? Yes and no. EDS and WorldCom entered into reciprocal outsourcing service contracts, for IT services from EDS and telecom network services from EDS. The two 1999 deals had minimum cross-purchase terms. So ends a chapter in quantifying EDS’s loss on a bankrupt customer.

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